A bank levy will not stop the doomsday cycle

By Peter Boone and Simon Johnson

Published: January 18 2010 19:59 | Last updated: January 18 2010 19:59

The last few weeks of political developments around the American-European financial system make us feel like we are back in the USSR. During the final years of communism’s decline, Soviet bureaucrats argued for futile tweaks to laws that would crack down on speculators and close “loopholes” – all in the vain hope they could keep the unproductive system of incentives intact. The US, UK and key European countries are now making the same errors. Rather than recognising the dangerous systemic failures in our financial system, their leaders are proposing bandages that can – at best – only postpone another, possibly much larger, meltdown.

There is growing recognition that our financial system is running a doomsday cycle. Whenever it fails, we rely on lax money and fiscal policies to bail it out. This response teaches the financial sector a simple lesson: take large gambles to get paid handsomely, and don’t worry about the costs – they will be paid by taxpayers (through fiscal bail-outs), savers (through interest rates cut to zero), and many workers (through lost jobs). Our financial system is thus resurrected to gamble again – and to fail again. Such cycles have been manifest at least since the 1970s and they are getting larger. This danger has even been recognised at the Bank of England, where Andrew Haldane, responsible for financial stability, recently published an eloquent critique of what he calls our “doom loop”.

Not surprisingly, Ben Bernanke, chairman of the Federal Reserve, does not agree that blame rests squarely with our monetary authorities. In a speech in Atlanta, he (incredibly) argued that extremely low interest rates on his watch – and decades of similar bail-outs of the financial sector – did not play a role in the recent collapse. Like an old-time Soviet bureaucrat, he put the blame on bad regulators and argued that more complex rules are needed to make regulation “better and smarter”.

When the Soviet Union fell apart, there were two competing views on what needed to be done: total change or tinkering. The establishment wanted tinkering – it felt much less threatening. This elite believed that if they could just get the rules right, the system would work well. But they completely missed the larger point – egregious loopholes in the rules were inherent to the system failing. In the Soviet Union then and in the US today, powerful lobbies profit from avoiding the rules, and a complex regulatory system actually serves them well as top lawyers and accountants seek out new flaws, or ensure they are represented in reform discussions. It is no surprise that Basel bank capital rules are discredited – the proposed Basel revision, with complex additional liquidity and risk-measuring systems, will fail just as surely.

This week, the US Treasury pulled its latest rabbit out of the hat: a tax on the liabilities of large banks. The Obama administration argues that, by penalising large institutions with such taxes, we can limit their future risk-taking. This logic is deeply flawed. Why would higher funding costs mean you gamble less? If you know Tim Geithner is waiting to bail you out, you may gamble more heavily in order to pay the tax. The UK “reforms” look equally unpromising.

In this regard, America’s top bankers appear much more honest, and focused on clear goals, than our policymakers. In his testimony to the Financial Crisis Inquiry Commission last week, Jamie Dimon, head of JPMorgan Chase, argued that regulatory failure was a major reason for our latest financial collapse. He did not try to argue that we could make it work – he just made the obvious point that, if there is potential failure to exploit, banks will naturally press any advantage to make profits.

For our top bankers, the fact that the system will only change marginally is fine. Phil Angelides, chair of the Commission, nailed Lloyd Blankfein, head of Goldman Sachs, with a metaphor for the age: Wall Street is in effect selling cars with faulty brakes, and then taking out insurance on the buyers. Blankfein naturally retorted: “I do not think the behaviour is improper.” Here we go again.

To end the doomsday cycle and prevent even greater damage to the real economy, we need dramatic reforms.

First, we must sharply raise capital requirements at leveraged institutions, so shareholders rather than regulators play the leading role in making sure their money is used sensibly. This means tripling capital requirements so banks hold at least 20-25 per cent of assets in core capital.

Second, we need to end the political need to bail out every institution that fails. This can be helped by putting strict limits on the size of institutions, and forcing our largest banks, including the likes of Goldman Sachs and Barclays, to become much smaller.

When the Soviet Union disintegrated, it took tough leaders and clear thinkers, such as Boris Yeltsin and Yegor Gaidar, to pick up the pieces and push for reform. It would have been easier and less messy if genuine reform had started before the collapse.

In the past few months it has become clear the US and UK don’t have sufficiently strong political leaders. There are good tough people around: Paul Volcker stands out in the US, as so does Thomas Hoenig, head of the Kansas City Fed, and Mr Angelides. In the UK, Lord Turner, Mr Haldane, and even Mervyn King are showing at least intellectual inclination towards more serious reform.

Let’s bring more such clear thinking into top policy circles now, rather than wait for another collapse.

Mr Boone is a research associate at the London School of Economics and a principal in Salute Capital Management. Mr Johnson is a professor at MIT’s Sloan School, a senior fellow at the Peterson Institute for International Economics, and co-author of the forthcoming 13 Bankers